December: Will U.S. politicians agree to agree?

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Despite the negative moves in the stock market after the presidential election, stocks at the end of November were actually up—but barely. Although it may be tempting to ascribe a lot of the market moves to the ongoing debate about the fiscal cliff, that would be ignoring many other factors driving the markets, for example: developments in Europe, China’s manufacturing beginning to accelerate, the impending elections in Japan, and the ongoing problems in the Middle East. By comparison, the fiscal cliff is more of a divot than a major driver.

> The economy
> Equities
> Bonds
> Asset allocation
> The bottom line

The economy

Third quarter gross domestic product (GDP) for the U.S. was revised up from 2% to 2.7%. Export growth ended up, adding to rather than subtracting from growth. Consumption spending grew more slowly than originally estimated, but inventory accumulation drove the bulk of the revisions. While 2.7% is a good growth number, the quality of growth wasn’t outstanding. Growth from inventory accumulation can be transitory, especially if sales don’t pick up.

Growth for the fourth quarter of 2012 is likely to slow, due to not only the disruption of economic activity due to Hurricane Sandy but the ambiguity caused by the ongoing debate about what to do about U.S. tax policy for 2013. This type of uncertainty can make consumers and companies sit pat for a bit, waiting for clarity. Depending on how the debate in Washington is resolved, we may see a continued slowdown in the U.S. going into 2013.

When evaluating what’s likely to play out in Washington, we think it’s important to look back to December 2010—when the Bush-era tax cuts were first set to expire. It wasn’t until November 30 that politicians even began to discuss an agreement. Within seven days, a deal was struck. We suspect that if a deal isn’t done within the first week of December, investors might get impatient with politicians and try to force their hand. We’d view that as a buying opportunity, though. Most likely, policymakers will come to an agreement to extend policies temporarily and to work on a more comprehensive agreement in the future. Politicians would, effectively, be agreeing to agree some other time.

We’d only become concerned if politicians agree to disagree and get nothing done. That would signal a type of political paralysis that would likely persist until the 2014 mid-term elections. While the actual economic effects of the tax increases and spending cuts that are part of the fiscal cliff would likely shave growth from 3% in 2013 to 0%, that’s hardly a devastating outcome. It’s not good, and it could keep market valuations from improving, but we don’t think it’s a reason to panic. Be concerned? Yes. Panic? No. The real effect the fiscal cliff negotiations will have will be on expectations about future policy changes and how the actual deal that is struck will change this outlook. In other words, the tax increases and spending cuts might not be as important as what the agreement says about future tax increases and spending cuts.

Housing is beginning to make contributions to economic growth. That will likely continue, if not accelerate. The Federal Reserve (Fed) is meeting on December 11 and is likely to announce that it will convert its current policy of selling short-term Treasury securities in exchange for longer-dated Treasury securities into a flat-out purchase program. While the Fed is buying $40 billion per month in mortgage-backed securities, it could increase that amount to help keep mortgage rates at record low levels. Keeping financing cheap is pretty much all the Fed can do to actually spur the economy on.

One place where monetary policy may abruptly change is Japan. A new election has been called, to take place on December 16. After rising to power in 2009, the Democratic Party of Japan (DPJ) is likely to lose power to the Liberal Democratic Party (LDP). The DPJ has not done much to help Japan get out of its deflationary trap, and the LDP has been very vocal in saying that the Bank of Japan (BOJ) should target a 2% rate of inflation. If the LDP takes power, as expected, investors should watch whether legislation is proposed that would effectively strip the BOJ of its independence. While a little inflation would probably help Japan, getting that inflation by compromising the independence of the country’s central bank could turn a little inflation into a lot over time.

While the European Central Bank (ECB), the International Monetary Fund (IMF), and the European Commission (EC) agreed to ease the debt reduction targets for Greece in order to release the next tranche of financing due to the Greek government, the decision was not made without acrimony. The IMF wants Greece to reduce its debt-to-GDP ratio more aggressively than either the EC or ECB wants. To realistically reduce Greece’s debt ratio would likely require official sector lenders to write down the amount owed, to lower the interest rate charged on loans, and to extend the maturity of the loans. The write-downs are the most controversial dimension of this debt debate. A write-down likely wouldn’t sit well with the German public, and 2013 is an election year in Germany, with Prime Minister Angela Merkel going up for reelection in September or October.

Equities

November was supposed to bring us change and certainty. Instead, little changed, and the uncertainty became more ingrained in our political system. After the expenditure of billions of dollars and trillions of unkind words, we are back to the same political leaders we had six months ago. We have the same president and the same leadership in the House and Senate; and now we know that we will have them for some time. We will have to get used to them, and they to each other.

While the potential economic damage of pre-ordained tax increases and spending cuts have brought both sides to the negotiating table, we expect these talks to be bitter and contentious. The concessions that each side expects of the other are contrary to hardened philosophies and will require the repudiation of promises and the tarnishing of ideals. They cannot appear to be lightly undertaken.

Each side must posture and challenge the other. At first, intransigence must appear a virtue and the willingness to compromise a sign of weakness or even panic.

The market’s reaction to the election gave us a preview of what is in store for the fiscal cliff debate

More importantly, we believe that an equity pullback would force the issue. No one wins in a stalemate, and both sides can hope to claim credit if a budget-shrinking compromise is achieved. We advise you to buckle your seat belts for December, but keep your eyes fixed on 2013.

Overall, November was not a bad month for U.S. equities

Among the sectors, the consumer was king. Despite the potential for higher income taxes in 2013, the consumer discretionary sector led the pack with a solid 3.2% return. Cyclicals, in general, tended to outperform. Both the materials and industrial sectors gained 1.7% in the month. Even the depressed information technology sector managed to advance 1.1% in November and get back a bit more of the 5% it had dropped in the prior two months.

Big dividend payers were at a disadvantage. The utilities sector proved to be a large drag on the market, with a 4.3% decline. The telecommunication services sector (which is dominated by a few large-capitalization, high-dividend-yielding stocks) fell back 0.9%. Also on the defensive were energy (down 1.4%) and financials (down 0.8%). We see value in the energy sector, with a chance for long-term appreciation. In financials, we do not see exceptional value, but we do sense the real risk of a substantially more challenging regulatory environment.

In summary, the U.S. equity market rose and seemed to shrug off the prospects of higher taxes and more stringent regulation. However, those fears did seem to show up within the sector and group performance.

A number of foreign equity markets also did well in November

We believe that these markets are looking beyond current economic weakness to the “less austere austerity” that they believe will come. Since the beginning of September, we have encouraged long-term investors build positions in these markets. We continue to do so.

Among the emerging markets, China was the weakest, falling 4.1% in U.S. dollar terms. Although downward pressure continues in China, we would invest in the industrial sectors while avoiding the financial sector. Other areas of strength were (all in U.S. dollar terms): India (up 3.4%) and Argentina (up 2.6%). Mexico and Hong Kong both added 1.8% in the month.

Resource-dominated markets lagged. Norway was up only 0.8% (all of it due to currency), and Russia eked out a 0.2% gain.

Bonds

The municipal market easily outperformed the rest of the bond market in November, as investors apparently decided that higher marginal tax rates are inevitable and will increase the demand for tax-exempt income. The strong November returns pushed the year-to-date return for the municipal market index to an astounding 630 basis points (bps; 100 bps equals 1.00%) above the return from the Treasury market. Moreover, in a month in which the taxable markets experienced a modest flight to safety, the A/BBB segments of the municipal market continued to outperform the AAA/AA segments. Last month, that outperformance was approximately 50 bps. Over the past 11 months, the A/BBB credits have outperformed the AAA/AA credits by approximately 400 bps.

Treasuries were the second-best performers in the taxable markets, ending a three-month string of negative returns from the 10- and 30-year maturities. Yields remained within relatively narrow ranges during the month, but even small declines in the longer maturities were sufficient to produce total returns above 1% for the 10-year notes and the bonds. The year-to-date return from Treasuries remains one of the weakest of any taxable sector.

Table 1: Year-to-date bond market total returns (%)

Market	2010	2011	Q1 2012	Q2 2012	Q3 2012	Nov.	YTD
Broad market index	6.80	7.80	0.37	2.17	1.66	0.23	4.70
Corporate	9.52	7.51	2.44	2.37	3.98	-0.08	10.40
Treasuries	5.88	9.79	-1.29	3.00	0.58	0.58	2.67
Agencies	4.61	5.27	-0.02	1.38	0.84	0.38	2.61
Mortgages	5.67	6.14	0.60	1.11	1.13	-0.21	2.45
Asset-backed	5.02	1.43	0.76	0.70	1.01	0.24	3.17
High-yield	15.24	4.50	5.15	1.83	4.61	0.74	13.78
Municipal	2.25	11.19	2.08	1.98	2.57	1.83	8.99
2-year Treasury	2.28	1.45	-0.10	0.10	0.20	0.09	0.25
5-year Treasury	6.76	9.20	-0.52	1.94	0.83	0.60	2.58
10-year Treasury	7.90	17.15	-2.23	5.81	0.92	1.17	5.31
30-year Treasury	8.65	35.50	-7.57	12.60	-0.37	1.48	5.11

Source: Bloomberg
Past performance is no guarantee of future results.

The power of incremental coupon income was apparent in the corporate market in November. Yields were flat to slightly higher in both the investment-grade and high-yield markets, due to a combination of profit taking and some resistance to what had become record low yields. Substantially greater coupon income from the high-yield bond market allowed it to post a positive return, while the investment-grade index recorded a negative return for the first time since March. The weakest credits within those markets, the BBB and CCC segments, recorded somewhat weaker returns than the stronger credits. That has been the typical pattern for months in which the corporate markets struggle somewhat.

The mortgage market performed poorly for the second consecutive month. After plummeting to near zero in September in response to the Fed’s decision to buy $40 billion mortgage-backed securities per month, mortgage spreads increased in October and most of November, to around 50 bps. While still about one-half what would be regarded as the typical spreads, the current spreads might be sustainable in a market where net issuance is extremely weak and the Fed is a big net buyer.

Asset allocation

Investment horizons

Equities

Value versus growth

Large caps versus small caps

Fixed income

Asset allocation summary table¹

Equity recommendations

Strategic recommendation Three years or longer: Overweight equities		Tactical recommendation Less than one year: Balanced allocation
Developed equities/emerging markets equities
Emerging markets have likely been oversold due to dire predictions about global economic growth.		Emerging markets are likely oversold, but considering the short-term uncertainty, we think it remains prudent to focus on global developed equities.
U.S. equities/non-U.S. developed equities
The ability to grow market share will likely be more important than the ability to grow earnings.		Valuations are attractive outside the U.S., but growth estimates of the U.S. economy are likely too negative.
Value/growth
Look for real growth, which can be in traditional value sectors. We think the theme for the next few years will be to identify mispriced growth opportunities. That means looking for value stocks in growth sectors and growth stocks in value sectors.		Health care and technology (not just information technology) remain our favorite areas. Growth with value characteristics or value with growth characteristics seems to offer the best investment opportunities.
Large/small
Overweight large-cap stocks because they tend to have the dominant market share and cash to survive a volatile environment.		Large-cap stocks are attractive, but some large-cap companies may be tempted to overpay for acquiring small-cap companies.

Fixed-income recommendations

Strategic recommendation Three years or longer: Overweight equities		Tactical recommendation Less than one year: Balanced allocation
Fixed-income duration
The Fed claims that rates will stay low until late 2015, but “low” could be 2%, not 0%. We think the Fed’s forecast is wrong and it will need to raise rates by the end of 2013. Thus, we believe you can ride low yields for a while, but not forever.		The Fed and other central banks will likely keep short-term rates low until the end of 2013. Thus, we think there is little reason to fight the central banks.
Credit risk exposure
Default rates are low, but investors need to be careful about new issuances. Some of the credit risk might not be worth taking on.		We think default rates will continue to fall, which should be good for high-yield debt, but it pays to be cautious, as junk issuers are getting too good of a deal.
Fixed rate/floating rate
We prefer fixed-rate short-term debt over floating-rate debt. Until the end of 2013, buying floating-rate debt might be like buying insurance for an unlikely event.		Some floating-rate debt may be prudent, but it really depends on the credit quality of the issuer. In general, we’d prefer to leave the decision to a portfolio manager who does bottom-up credit analysis.

The bottom line

¹The asset allocation positioning represented by the bar graphs is in no way intended to offer individualized advice about which investments to choose or how much to allocate to any particular investment option. The asset allocation dials are provided for illustration purposes only and do not predict or guarantee the performance of any Wells Fargo Advantage Fund. When applying an asset allocation strategy to your own situation, variables such as your investment objectives, time frame, income requirements and resources, inflation, and potential rates of return should be considered when you determine which investments will best suit your risk profile. Please consult a financial advisor for advice on your specific facts and circumstances.

The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index, with each stock's weight in the index proportionate to its market value. You cannot invest directly in an index.

The Russell 3000^® Growth Index measures the performance of those Russell 3000^® Index companies with higher price-to-book ratios and higher forecasted growth values. The stocks in this index are also members of either the Russell 1000^® Growth Index or the Russell 2000^® Growth Index. You cannot invest directly in an index.

The Russell 3000^® Value Index measures the performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values. The stocks in this index are also members of either the Russell 1000^® Value Index or the Russell 2000^® Value Index. You cannot invest directly in an index.

The Value Line Composite Index is an equal-weighted stock index that contains 1,700 companies from the NYSE, American Stock Exchange, Nasdaq, and over-the-counter market. You cannot invest directly in an index.

The Dow Jones Industrial Average is a price-weighted index of 30 "blue-chip" industrial U.S. stocks. You cannot invest directly in an index. 

The NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market. You cannot invest directly in an index.

The views expressed are as of 12-4-12 and are those of Chief Portfolio Strategist Brian Jacobsen, Chief Equity Strategist John Manley, Chief Fixed-Income Strategist James Kochan, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.